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Angels in Chicago: Seed Investment for Startups

Here we will investigate the level of competition for investment deals in Chicago, problems that angels see in business plans and proposals, incubators as an alternative to angels, and offers some sage words of advice for entrepreneurs from the angels.

Competition for Deals

Recently, Fred Wilson, a well-known venture capitalist and principal of Union Square Ventures in New York, wrote, “…there are a few storm clouds out there that we need to be watching. In particular, I think the competition for “hot” deals is making people crazy and I am seeing many more unnatural acts from investors happening. If it were just valuations rising quickly, I’d be a bit less concerned. But we are also seeing large deals ($5mm to $15mm) getting done in a few days with little or no due diligence. Investors are showing up at the first meeting with term sheets. I have never seen phases like this end nicely.” So, are Chicago angel investors seeing this kind of “frothiness” in the local market?

In general, Groupon notwithstanding, the answer is no. Jeff Carter: “There is competition for deals. That’s good…but it’s a small pond. We are more than happy to work with other groups, as long as it’s not a one way relationship. It pays for all angel groups to support the other. The key is to turn the pond into an ocean.” Andy Hagans said “The funding dynamics seem to be healthy and competitive from both ends of the deals, in my experience.” Lon Chow’s view is that “In my experience, deals in Chicago are generally not competitive. One investor sets the price and terms, and that becomes the basis for the deal (with some negotiation on both sides.)”

Nick Rosa’s view is that “We’re pretty practical in Chicago. You can’t get funding here if your concept is nebulous and, perhaps, too “fluffy”. It might be easier to go to the coasts to get funding (for those kinds of opportunities). There’s a little more reality put on the business opportunities here. It’s hard for me to get behind a business that we don’t understand. We (Sandbox) questioned a couple of deals that came to us, and were told by the entrepreneurs that ‘we can go to Silicon Valley and get $500K for this as it is; we don’t have to develop it further.’ As for term sheets, there’s always a little bit of negotiation, but I don’t believe that we’ve ever run into a situation where we couldn’t come to an agreement once we came to the term sheet phase.”

What Problems do Angels see in Proposals?

Angels and funds see hundreds or even thousands of proposals each year, in the form of inquiry letters, presentations and business plans. What are some of the most common problems that angels see with these proposals?

According to Jeff Carter, the common problems include:

A valuation that’s too aggressive. Valuation needs to be looked at as a growth strategy. Come out with a too high valuation, (and) that next round is going to be tougher. Entrepreneurship is like a battle, the best laid plans blow up once you fire the first shot.

There’s not enough contemplation about the exit. Google and Yahoo can’t buy everyone.

Market sizing: The thing we hear a lot is that the market is X billion, and if I get 2% we make money. Why can’t you take the whole thing? If the technology is disruptive enough, you can.

Entrepreneurs underestimate their competitors. Give me really good reasons why someone won’t enter your space, or if there truly are no competitors why will people switch what they are currently doing to use your solution? It can’t just be pure cost, there has to be something else visceral to make the switch.

Also, the business ought to be a solution to a pain point in current businesses that’s big enough to make the venture scalable. The entrepreneur might really have a good business idea, but if it’s a lifestyle business, it’s not necessarily a great angel opportunity. It’s going to make money for them, but not for investors.

Andy Hagans has a different approach—here’s what he says: “I have what I call my ‘One Dollar Rule.’ If I see a presentation and it’s nothing but a prototype (with no signed sales contracts), I pass. If I see a company with a launched product but they’re not monetizing yet, I pass. All I am looking for is literally one dollar of revenue in your company’s history… revenue traction of any kind. So you could argue that I would have passed on Twitter, and passed on Google, and would be passing on all sorts of genius inventions in the prototype stage, and you’d be right. But since my circle of competence is more or less in the Web startup space, I do run into a lot of presentations where the company has the attitude of “we’ll monetize later”, which I simply can’t get comfortable with.”

“I’m not saying all of the above should apply to most investors or entrepreneurs; that’s just a rule I have involving my personal comfort level and circle of competence. If I can’t get comfortable with the business plan, then I don’t trust my ability to be an oddsmaker and pick a winner.”

Lon Chow says he needs answers to a number of questions: “Do I want to invest in this person’s company? Is it a good business? Seasoned entrepreneurs are generally good at presenting their businesses, while new entrepreneurs may need to be guided with specific questions to get at the key information about themselves and their companies.”

“It’s not about the presentation; in fact, I haven’t read a single business plan while I’ve been at Apex. It’s about the interaction between me and the entrepreneur(s). Over time, I’ve learned that good entrepreneurs are good thinkers, and good thinkers usually make good presentations.”

One “pet peeve” he has is that “People put buzzwords into their presentations and compare themselves with companies and sectors that are hot. They’ll say ‘We’re the X of Y’ (where the X is Facebook, Google, Twitter, Groupon, etc.). Analogies can go wrong.”

According to Nick Rosa, “It’s human nature to do a business plan assuming that everything goes right, and most new business ventures don’t take into account contingencies or scenario planning. We like to ask ‘What if this path doesn’t work? Will you still have something at the end of the day?’ There’s always a lot of optimism, which is a good thing, but we ask for the fallback plan.”

“People also generally underestimate the amount of cash they’ll need to get to certain milestones. We like to see things happen on the basis of milestones; it’s nice to look out three years, but what’s going to happen next month or in three months? It’s nice to think about having a million visitors to your website, but how are you going to get the first hundred or thousand?”

The Incubator Option

As discussed earlier, Sandbox Industries runs an incubator, and there are several other incubators in Chicago, including TechNexus, run by the Illinois Technology Association, the SYNC Technology Center, Excelerate, ScaleWell and Technology Innovation Center in Evanston. Quoting again from Wikipedia: “Incubators are programs designed to accelerate the successful development of entrepreneurial companies through an array of business support resources and services, developed and orchestrated by incubator management and offered both in the incubator and through its network of contacts.”

Incubators offer not only space for housing a seed-stage startup, but support services and, in many cases, seed capital. Incubators rarely invest more than $25,000 in a startup, but the facilities and professional advice that they provide can add considerable value.

Terry Howerton has been the Chairman of the Illinois Technology Association (ITA), the operator of the TechNexus incubator, since 2005. ITA was originally founded to build a more connected, collaborative technology community in Chicago, and to help to move Chicago’s high tech industry from a vertical orientation (primarily business-to-business solutions focusing on a single industry, such as finance, travel or real estate) to a more horizontal orientation (with both business-to-business and business-to-customer solutions for a broad range of applications).

Today, the ITA has over 700 member firms, from one-person companies to some of the biggest technology firms in the city, including Orbitz, Nokia’s NAVTEQ subsidiary and IBM’s SPSS. According to Terry, ITA is now shifting its role to assisting technology companies in the area to achieve rapid growth over the next five to ten years. For example, the ITA’s Fall Campaign identified approximately 1,000 of the top computer science graduates from colleges and universities throughout Illinois. It brought the 45 best to Chicago for a competition, where they could meet technology employers and be encouraged to stay in Chicago rather than take jobs in Silicon Valley, New York or Boston.

The ITA’s TechNexus has incubated 57 startups and these startups have attracted $48MM of investment for themselves, most of which came from investors outside Chicago. Terry believes that incubators are critically important for the development of startups in Chicago, perhaps more important here than in Silicon Valley, where access to resources is easier. He claims that there is more investment capital in the six blocks surrounding the ITA’s offices in the Loop than in all of Silicon Valley (the ITA is near the Chicago Merchantile Exchange), and the challenge is for the ITA and other organizations to get family investment funds from the North Shore, as well as commodity investors, to begin making venture investments.

In Terry’s view, the lack of venture capital funds in Chicago that can do Series A and later rounds is an even bigger problem than the number of angel investors in the city. Startups that get angel funding can’t expand if they can’t get later-round funding. There are only three or four venture capital funds based in Chicago that are making these later-stage investments, including Apex and Sandbox, so funds from cities including Louisville, Cincinnati and St. Louis are coming to Chicago to find investment opportunities. He believes that if local investors can be persuaded to invest in later-stage funds and gain experience, they’ll eventually have the confidence to participate in seed rounds as well.

Some Final Words of Advice

All of the angel investors we interviewed for this article had some final words of advice for entrepreneurs looking for seed capital. Jeff Carter advises, “Research the angel group that’s offering you an investment. Don’t let them hand you a check and wish you luck. You want the angel group to have someone that can make some connections for you, mentor you and help you. I detest angel groups that really act like investment bankers. They aren’t interested in making money off the business, but rather, are more interested in making money off the capital they raise for the entrepreneur and in “free riding” by taking a piece of their equity.”

Andy Hagans offers these words of encouragement: “You have to keep your head up and keep knocking on doors, even if you get rejected twenty times. It isn’t always about being the “best” presentation an investor sees — a lot of it has to do with their personal expertise, their comfort levels within various fields, etc. It’s like when you get dumped, and the other person says “it’s not you, it’s me,” but in this case it’s usually true. If you’re willing to get rejected twenty times then the odds of your raising money are actually pretty good.”

Lon Chow suggests that you work your personal and business network to make connections and get introductions to potential investors. One of the biggest challenges is your ability to seek out investors and make contact with them—if you can do that, you have a much higher probability of success in your business overall. Finally, do your homework about investors. Make sure that the investors you’re pursuing make investments in your product or market area, and make seed investments.

Nick Rosa says, “You have to talk to a lot of people. You really have to get out there with your idea. If you meet one angel investor who says that your business isn’t right for them, you should ask “Do you know someone for whom it is?” Take advantage of the fact that a lot of the angel investors know each other, and know someone who might want your idea, but you have to do the asking.”

Finally, Terry Howerton has a few suggestions for success:

Build the most impressive advisory board you can. Go find mentors who have “been there and done that.” They know how to get the capital and from whom.

Don’t be afraid to share your idea. For startups, the idea is very rarely the “secret sauce”; it’s almost always the execution. If you share your idea, you’ll get feedback that can help make it better, and identify people who can help you raise capital and run your business.